FOOL'S EYE VIEW
Get Ready For The Revolution!

By Cliff D'Arcy
January 17, 2006

If you're one of the 24 million people who refuse to cut back on their spending to save for retirement, then stop reading now, because ignorance is bliss. Just sit back, safe in the knowledge that you're going to live a hand-to-mouth existence when you stop work! The rest of you, read on.

Recently, someone asked me why tax years in the UK run from 6 April one year to 5 April the next, instead of being aligned with the calendar year.

I explained that, historically, the financial year in the UK began on 25 March, known as Quarter Day or Lady Day. However, after England switched from the Julian to the Gregorian calendar, eleven days were eliminated from the calendar in 1752, pushing back the start of the tax year to 5 April. This strange fact explains why, uniquely, British tax years begin on 6 April. Weird, huh?

Anyway, 6 April 2006 marks not only the start of the 2006/07 tax year, but the dawn of a new era for pensions. On what's known as "Pensions A-Day", the government will sweep away the eight existing tax regimes, and replace them with a single universal regime for tax-efficient retirement savings.

The good news is that pensions simplification will make life easier for individuals, employers and pensions providers. We will enjoy greater choice and flexibility in how we save for retirement, plus red tape and administrative costs will fall, making pensions simpler and cheaper. At least, that's the idea!

Rather than explain the current pensions regime in any detail, I'll cut straight to the chase by revealing what the new world of pensions will look like in just over eleven weeks' time. Broadly speaking, the A-Day changes fall into six categories, as follows:

1. A higher retirement age

Currently, you cannot start taking a pension before the age of fifty (unless you're in a special category, such as professional sportspeople, who can take benefits as early as age 35). However, this minimum age will be raised in the coming tax years, reaching 55 by April 2010. This means that people who wish to retire early may need to get a move on, or look at vehicles other than pensions to fund the early years of their retirement.

2. A single, higher contribution limit

Currently, there's a whole host of complicated rules limiting what you can pay into your pension each tax year while still receiving tax relief. From 6 April, the only limit will be 100% of your gross (pre-tax) annual earnings, up to a ceiling of £215,000 in the 2006/07 tax year. This cap will be raised in increments of £10,000 until it reaches £255,000 in 2010/11.

If you don't have any earned income, you will still be able to contribute up to £3,600 per tax year, as per the current Stakeholder regime. So, all but the very wealthiest of us will be able to put more into our pensions, which is good news all round. Then again, how many people will actually do so remains to be seen!

3. A limit on large pension pots

This is where things get complicated. A Lifetime Allowance is to be introduced. Initially, this will be set at £1.5m for 2006/07, rising to £1.6m in 2007/08, and then raised in £50,000 annual increments until 2010/11, when it hits £1.8m. If the total value of your pension pot exceeds the Lifetime Allowance in the year that you retire, any excess over the limit will be taxed at rates of up to 55%. (Remember that you've earned tax relief of up to 40% on the way in, so this isn't the daylight robbery that it first appears!)

To be frank, this isn't going to be a big deal to most of us, since only the very highest earners (say, one in fifty workers) will be affected by this lifetime limit on pension values. Obviously, if you earn more than, say, £75,000 a year, you probably don't have too much to worry about on the financial front, anyway! However, if you do fall into this elite category, you can "register" current pensions to protect them from this tax threat. Therefore, it may be worth taking expert advice from a properly qualified financial adviser, such as one who has passed the G60, K10, K20 or CF9 papers.

4. Small pension pots can be cashed in

At present, any pension pot worth more than £2,500 must be used to purchase an annuity -- a retirement income for life. However, from 6 April, if you are aged between sixty and seventy-five, you are free to take up to 1% of the above-mentioned Lifetime Allowance in cash.

Hence, next tax year, if your combined pension pots are worth less than £15,000 in total, you can withdraw the lot in cash, with a quarter (25%) of this cash available tax free. Thus, if you don't have a large amount stashed away in pensions, it may be worth cashing them in after A-Day, rather than using them to buy an income in the 2005/06 tax year.

5. Withdrawing tax-free cash

At the moment, most people with a personal or company pension can withdraw up to a quarter of it as tax-free cash on retirement (higher limits apply for certain older plans). Alas, if you've contributed extra payments into your pensions, known as Additional Voluntary Contributions (AVCs), you cannot take these as part of your lump sum. Other pensions that cannot be used to fund tax-free cash include contracted-out State Second Pension (S2P) pots.

However, come A-Day, you can take 25% of any pension pot (up to the Lifetime Allowance) as a tax-free lump sum. Consequently, delaying taking these benefits until after A-Day may mean pocketing a larger tax-free payout.

6. A new form of retirement income

At the moment, you must use your pension pot to buy an annuity by your 75th birthday. After 6 April, you'll have a new option, known as an Alternative Secured Income, which enables you to take an annual (taxable) income without handing your fund over to a life assurance company. When you die, the remaining pot can provide one of your dependents with a pension, or can be given to another member of the pension scheme or to charity.

Furthermore, two new types of annuity are to be introduced: Limited Period Annuities and Value Protected Annuities. The first will run for five years, after which time you can buy another annuity, or opt for a normal lifetime annuity. The second will pay out any unused sum to your heirs, but pays a lower income than a standard annuity.

Summary

Incidentally, if you're a member of a company pension scheme, you no longer have to retire in order to receive your pension. Instead, you can keep working, while taking some or all of your accrued pension benefits.

So, if you have a private or occupational pension, you may need to make some decisions before A-Day (especially if you intend to retire in the next few years), or you could lose out. People with the smallest and largest pension pots have the most to gain (or lose) from A-Day, so now is a good time to plan ahead.

To help you to get to grips with A-Day and understand the choices, opportunities and risks, financial watchdog the Financial Services Authority (FSA) has launched this dedicated website. The FSA has provided a range of tools and resources including a jargon buster, consumer guides, comparative tables for pensions and annuities, plus a checklist for people thinking of retiring soon.

More: Learn more -- or choose a pension -- in the Fool's Pensions centre | How To Avoid Pension Poverty.